Whenever a recovery begins in crude oil prices and natural gas, it always begins upstream, usually very far upstream. As I have noted before, this is signaled in the oilfield services (OFS) segment of the energy sector.

My tracking index for OFS companies currently follows 63 providers of early field development and preparation. These include everything from initial geological surveys, through seismic, analysis, test and exploratory wells, to pad preparation, drilling, well completion, maintenance, support, and workover rigs.

Before the improvement is recorded by the operators – the firms actually producing the oil and gas – we should expect a spike to take place in OFS. These are the providers who will experience a push before anything is extractable. Normally, indications of a recovery occur in OFS first.

It appears the recovery is happening again this time. All 63 stocks on my tracking list are up for the week (by an average of 4.5%) and 60 are up for the month (with an average rise of over 14% for all 63).

As we go forward, there's one strategy you should use to play this recovery…

A Rising Tide Doesn't Lift All Boats

The current market dynamics are hardly affecting the entire tracking list evenly. Some of the largest companies can parlay international exposure to offset continuing weaknesses in selected regions or service areas (although this can also be a liability if the company is exposed to projects in geopolitical hot spots). There are also locally specific companies in seismic and well completions that are not likely to perform as well as more diversified OFS providers.

But the strengthening of the segment is apparent nonetheless. The question always arises, how to gauge the advance and the relative advantage of investing in one company rather than another?

To begin with, one must understand that not all segments of OFS or manufacturers and distributors of the equipment used in field work will be affected in the same way. In each of the previous cycles of OFS contraction, there has been pronounced consolidation with the largest companies acquiring both horizontally (competitors in the same primary service category) and vertically (moving "up" to absorb equipment producers and "down" into those services closer to actual wellhead flow).

The big boys may be getting bigger during such periods, but they are also experiencing greater exposure to risk during the next downward pressure on OFS as a whole. Whenever companies expand vertically, they are seeking to control as many distinct aspects of an overall process, thereby allowing internal transfer pricing to replace the usually more expensive market pricing when using material or services from a genuinely separate company.

However, unless the OFS companies move into actual field production operations (that is, become responsible for the actual extraction of the oil) or acquire an ownership position in facilities further downstream (futures contract trading of the actual commodity, or refining and product distribution, for example), they have no control over access to fields.

Lessening access to alternative field service sources by absorbing the competition, therefore, is of little advantage if the demand for the services declines. Even if an OFS giant does shift into actual field operations, it still cannot control market demand for the raw material or the processed product stream.

Comparing individual companies in this sector, therefore, can be a tricking undertaking.

Focus on Sector ETFs to Gauge Success

The way to offset this problem is to track the overall progress of OFS company performance is by monitoring four exchange-traded funds (ETFs) that follow both the field service component and the field equipment lines required.

Such ETFs are not usually the best OFS investment tools, given the uneven nature of the companies included and the fund fees and charges. Use these as barometers of the broader segment and as yardsticks for appraising the relative return strengths of specific stocks.

Oil Service Holdrs ETF (NYSE MKT: OIH), which has the highest market cap.

All of these are in the black. XES is up 6.9% for the week and 7.6% for the month as of open on January 7; PXJ 7.1% and 7.5%, respectively; IEZ 6.9% and 5.9%; and OIH 6.3% for the most recent week and 4.4% for the current month.

While comparisons of a few ETFs are rarely the best way to approach any market sector, it does provide a thumbnail sketch of what is happening. OIH may provide the best indication of what is taking place among the broadest range of field service providers, but also carries higher fees than ETF market averages before the share value is determined.

Meanwhile, PXJ provides a more focused OFS coverage and a lower fee charge, but relies heavily on better known and larger companies. On the equipment side, IEZ is the best barometer, but does not provide a workable bridge to the OFS providers themselves. There is also the problem of lag time between the ordering of equipment and its actual usage in the field.

While I employ all four ETFs in a more complicated algorithm, there is a rather straightforward way of using two of them in investment decisions. XES ends up being the most reliable single tool, combining both the mainstay companies on the equipment side and in the service segment, while the market cap size of OIH is the best indicator of what investment trends are doing in the sector.

Employ The Two-Step ETF Process

A simple way to begin using these ETFs as yardsticks for the entire sector would involve a two-step process.

First, determine a ratio between XES and OIH – .6 XES to .4 OIH is a good starting point.

Second, apply the aggregate percentage increase from this calculation to individual stocks.

If XES increases say 5% over a certain period while OIH increases 4%, the aggregate would be 4.6 [(5×0.6)+(4×0.4)]. A stock increasing more than the aggregate should justify further examination. Comparison of individual company specific considerations are then in order (for example, recent project announcements, acquisitions or spin offs, debt levels, P/E ratios, and so on.).

If the entire OFS sector is expanding, as is the case currently, you may need to readjust the ratio to reflect a slightly higher equipment-to-field component (XES) than trading volume (OIH).

The opposite may be necessary if the sector is experiencing downward pressure. Of course, once that move down becomes too pronounced, de-emphasis of the entire sector in your Portfolio may be the best move.

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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